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Buried halfway through a 240-page European Commission working document are proposals that would mean, if implemented, a major shake-up for high-frequency trading in Europe.

Photo credit: Alamy

Regulators globally have been eyeing HFT firms and the impact on market stability of their superfast, computer-driven trading. So far most of the ideas aim to ensure HFT firms are licensed and check their computers carefully before connecting them to markets.

These are the sort of measures proposed in the EU’s revised Markets in Financial Instruments Directive, dubbed Mifid II.

But starting on page 127, in the depths of the “European Financial Stability and Integration Report 2013”, issued last month, are much more radical ideas. Asking HFT firms to come to a gentleman’s agreement not to trade too quickly? It may seem incredible but that’s one idea floated. Or changing the deep structure of how stock markets work? Again, this is a measure that is analysed.

These ideas are certainly not yet EU policy. But the paper makes it clear that there’s support within the Commission for the idea that HFT firms are engaged in an expensive technological arms race that can generate risk-free profits but creates no economic value. The report cites studies that say that all the cash HFT firms spend on ever-faster trading systems in their “speed arms race” comes out of the pockets of ordinary investors.

Here are the four proposals – with a Financial News analysis of whether they would work.

Related

The rule would have required all orders to remain on a trading venue for at least 500 milliseconds before they are cancelled.

Such a restriction would help to tackle the notion that the liquidity provided by HFT firms is ephemeral and disappears when market conditions are unfavourable. It would also create a more even playing field for long-term institutional investors and HFT firms.

However, many are worried about the impact speed limits would have on liquidity.

Some high-speed trading firms act as marketmakers, ready to provide liquidity to buyers and sellers of stocks as soon as they need it. Part of the marketmaking process requires orders to be cancelled and repriced in line with market activity.

The paper notes that “liquidity providers will suffer losses if they cannot cancel orders when the market moves against them. As a result they may simply widen spreads or exit the market entirely”.

Johannah Ladd, secretary general of HFT lobby group the FIA European Principal Traders’ Association, said: “Asking a marketmaker to put quotes in the market and sit there exposed is basically like asking them to sit there with their wallets open. Marketmakers would either widen their spreads very significantly to create a risk buffer or they would exit the market and become opportunists.”

Joe Saluzzi, co-founder of US agency broker Themis Trading, admitted that it would be extremely difficult to regulate speed directly. Another approach that would be easier to implement is to limit the information HFT firms receive through high-speed data feeds.

Saluzzi said: “The data feeds used by HFT firms include extremely valuable information that they use to model order flow. This information could be limited without hurting the wider market because all traders would still be able to get the basic market information they need.”

Arjun Singh-Muchelle, senior adviser on regulatory affairs at UK buyside trade body the Investment Management Association, said: “The regulation of speed is a blunt tool, where something more nuanced and more subtle may work. Rules should be concentrated on the predatory strategies that some prop traders use.”

An alternative method of speed control mentioned in the paper is to decrease the importance of speed below the millisecond level. Currently, most markets work on a price-time priority, whereby the orders that arrive first are executed first.

The paper suggests giving the same priority to all orders that arrive within the same millisecond, a move the paper admits would create an “ambiguous” effect.

Ladd said trading venues should decide whether to introduce mechanisms to slow down trading, rather than being forced to via regulation, but added: “Rules or market models like this make it easier for people with inferior technology to compete, which ultimately lowers the incentive to innovate. We should be using the technology available to improve infrastructure, risk controls and to make the rules more robust.”

Some markets have been designed to negate the advantage of speed, not least IEX Group – the start-up US exchange whose executives are regarded as the heroes of Michael Lewis’s recent book Flash Boys. IEX limits the speed advantage HFT firms have by adding a short delay to all incoming orders.

• Private agreements on speed activities

The European Commission paper said: “High-frequency traders may be better off by not investing in speed, but the individual rationale of each trader provides a strong rationale to deviate.”

The paper refers to the race among HFT firms to be the fastest and reach the market first and cites the $300 million invested by telecommunications firm Spread Networks in a high-speed cable connecting New York and Chicago that was rendered obsolete by even speedier technology after just a year.

The paper added: “It is doubtful that trading ever closer to the speed of light leads to any benefits in terms of market quality.”

One solution proposed in the paper is for market participants to agree not to engage in mutually offsetting investment or activities related to speed. While such an agreement sounds good in theory, making it work in practice might be too challenging.

Joe Saluzzi at Themis said: “Limiting the arms race is an interesting concept but I seriously doubt it would be possible, mainly because it would be considered as anti-free market.”
Moreover, such an agreement would be hard to monitor and it would require fierce competitors to have faith in each other.

Johannah Ladd at the EPTA said: “It would be impossible for anyone who agrees to this to verify the actions of their competitors.”

She likens the logic of the private control agreement to discussions on banning co-location, the practice of placing trading servers as close to a trading venue as possible to reduce the time it takes for orders to reach an exchange.

Such a limitation, she argues, would only create opportunities for the same activity to occur in an unregulated way.

Named after economist Arthur Pigou, a Pigovian tax is a levy applied to a market activity specifically because it generates negative externalities, or costs for someone else.

Such taxes, which are designed to be set equal to the costs of other market participants, help to avoid heavy-handed regulation while adding to government coffers.

Such taxes are not an entirely novel idea. France and Italy have already introduced financial transaction taxes, and they are among 11 member states that have agreed next year to introduce an EU-wide FTT under the EU’s “enhanced co-operation” framework.

The Commission said that broad financial transaction taxes were an option, but added that such proposals were “not without risk since they would indiscriminately kill large and diverse niches of trading activity with far-reaching unintended consequences”.

Research by Credit Suisse last month found that in the 12 months since the introduction of Italy’s FTT on equities in March 2013, the average daily turnover in Italian stocks fell 29.7% when compared with January to February 2013. During the same period, trading in stocks from European countries excluding Italy grew by 4.5%.

Declines

Average daily equities turnover on stocks in France dropped 9.2% in the 20 months since the introduction of its levy in August 2012, versus January to July 2012. Trading in all other European stocks dropped by 2.8% in the same period, according to the research.

Sam Tyfield, a partner at law firm Vedder Price and former chief operating officer at HFT firm Automat, said: “The pros and cons of taxes have been the topic of much debate but the primary issue is that taxes would be passed down to the end consumer.”

The Commission paper proposed more direct taxes, such as a tax on rapid order cancellations that often characterise HFT activity. Earlier this year, new German rules on HFT forced exchanges to charge penalties on excessive order-to-trade ratios and a penalty for “excessive system usage” based on daily limits for the number of transactions sent by a single participant.

However, such taxes would need to be global, otherwise it would allow a “huge regulatory arbitrage opportunities to arise”, Tyfield said.

• Use of batch auctions

A more subtle proposal to rein in high-speed traders is to introduce “batch auctions” – share auctions throughout the day modelled on the auctions that exchanges use to set opening and closing prices.

This would require exchanges to replace the continuous central limit order book model with a series of uniform-price, sealed-bid auctions. The Commission paper suggests that auctions could be at “discrete time intervals, such as every one second, or 100 milliseconds”.

While the London Stock Exchange has recently opened a consultation into the proposal of introducing an intra-day auction at midday, multiple auction sessions have not been widely adopted by European trading venues.

Auctions are valuable during the busy open and closing trading sessions because they provide orderly and fair trading and help to minimise price volatility. They work by allowing participants to place orders at certain buying or selling prices, with matching bids and offers paired together.

Advantages

The European Commission paper said the benefit of a batch auction was that it “changes the nature of competition among fast traders, encouraging competition on price instead of speed. This ultimately benefits fundamental investors, via deeper markets with better prices”.

The theory goes that in continuous trading, although many high-speed traders observe the market at the same time, somebody will always get information and act first. In a batch auction environment, multiple traders will trade based on information observed at the same time, forcing traders to compete on price instead of speed.

Concerns about this approach centre on the fact that auctions are predominantly used at the opening and closing of the trading period as these are the times when liquidity is greatest. During the rest of the day, there may not be sufficient liquidity in the market to sustain auctions on an ongoing basis.

Furthermore, current legislation allows continuous trading to be replaced with batch auctions, yet market forces have not yet delivered such a mechanism.

Sam Tyfield of Vedder Price said: “My main concern with batch auctions is that if they are introduced in Europe, the rest of the world will be moving along merrily without them.”

Johannah Ladd at the EPTA said: “Our members’ views are mixed, although they generally feel they are contrary to the basic requirements of electronic markets, which is certainty and immediacy. It would interrupt continuous trading, would be detrimental to best price formation and would provide no certainty over when trades are executed.”

--This article was first published in the print edition of Financial News dated May 26, 2014